In a troubling financial analysis, Financial Samurai recently penned a post outlining why he thinks you’ll need $8 million for a “modest retirement.” If you just choked on your coffee, you read correctly. He argues you need an $8 million nest egg to produce a humble $40,000 in annual retirement income.
Why? What happened to the 4% rule?
For reference, the 4% rule refers to withdrawing 4% of your nest egg in the first year of retirement, then raising that amount for inflation every year thereafter. Historical data suggest you won’t run out of money for at least 30 years if you follow a 4% withdrawal rate. Following the 4% rule, a $1 million nest egg would produce $40,000 in income year 1, with modest inflation adjustments each year thereafter.
The Samurai points out that the 4% rule was first introduced in the 1990s, at a time when 10-year Treasury notes paid around 5%. According to his logic, that meant you could earn a 5% return basically risk-free, so a 4% withdrawal rate was as safe as it could possibly be.
On the one hand, I disagree with his conclusion. Very few of us are ever going to reach $8 million, yet somehow we’ll retire without starving. Consider that Bill Bengen, the financial planner who first proposed the 4% rule, looked at many decades of data going back to the early 20th century. He demonstrated mathematically that a portfolio of 60% stocks/40% bonds would not have run out of money following a 4% withdrawal rate in any 30-year stretch during the 20th century.
If you’re wondering, the same holds true for the two decades since.
Still, the Samurai isn’t wrong that we should question our financial assumptions, especially after the economic devastation caused by the coronavirus pandemic. Far too many of us think $1 million will make us “rich,” or at least comfortable for the rest of our days.
But what does a $1 million retirement actually look like?
Like so many complex questions, the answer is “it depends.” Here’s what it depends on—and what you can expect from a $1 million nest egg.
The Question of Social Security
Let’s start with the elephant in the room, Social Security. As one BiggerPockets blogger so bluntly put it, if you think you’re going to retire with Social Security, think again.
I have no doubt that Social Security will exist in some form or another by the time I’m eligible for it. I also have no doubt that it will pay me far less than it would today, in terms of real dollars.
Consider a study by the Senior Citizens League, showcasing that the purchasing power of Social Security benefits has fallen by 30% since 2000. Social Security has slowed its annual cost of living adjustments (COLAs) to rise slower than inflation, diluting the benefits over time.
While the Social Security Board of Trustees claims it will not be insolvent before 2035, the shockwave of COVID-19 could dramatically change that math. No one knows for certain what Social Security will look like in 10, 20, 30 years, but expect weaker benefits.
Sooner or later, Social Security will raise the age scale for benefits distribution. We can also expect continued watering down of benefits through COLAs trailing inflation.
Expenses & Cost of Living
There are countries where you can live a comfortable lifestyle for $2,000 per month. That includes dinners out, weekly maid service, the works. I personally live in Brazil, and while we spend more than $2,000 per month, we also have a full-time nanny, enjoy unrestrained meals out, and do plenty of international travel, all for between $3-4,000 per month.
Even within the U.S., cost of living varies widely. The median home price in San Francisco is nearly 10 times higher than the median home price in Greensboro, North Carolina. All of this goes to show that depending on where you want to retire, $40,000 could let you live comfortably or could put you below the local poverty line.
Beyond where you live, your actual monthly spending plays a role, as well. If neither you nor your spouse has a penchant for designer clothes and accessories, you’ll do better than your spendthrift counterparts.
Your cleverness and creativity also play a role. It helps—a lot—if you don’t have a housing payment, through tactics like house hacking. While you can do it by buying a duplex and renting out the other unit, you can also get more creative to house hack suburban single-family homes. Strategies like bringing in housemates, creating basement or garage apartments, renting out storage space, building an ADU, or even bringing in a foreign exchange student can all help reduce or eliminate your housing payment.
FIRE & “Forever Income”
Don’t want to work until you’re 65? Neither do I. In fact, I’d like to reach financial independence within the next few years, able to cover my living expenses with passive income alone.
By following a lifestyle with low living expenses, a high savings rate, and aggressive investing, you can reach financial freedom in your 30s. But when you plan to reach financial independence/retire early (FIRE), you need your nest egg to last longer than 30 years. The 4% rule doesn’t cut it.
You can still pursue FIRE with a traditional asset allocation of stocks and bonds. Financial planner Michael Kitces breaks down how a 3.5% withdrawal rate would actually leave your nest egg intact indefinitely, at least based on historical data from the last century or so. The nest egg would compound and grow faster than you deplete it at that withdrawal rate. So, a $1 million nest egg could therefore generate $35,000/year in income and last forever.
While I appreciate his calculations and invest in plenty of stocks for long-term growth, I also know I can generate better ongoing yield with real estate.
The Role of Real Estate
I’ve written extensively about how real estate can help you retire on less—or inversely, help you generate more income from the same cash investment.
To begin with, real estate can change the math of traditional retirement investing, given its potential for high annual yield (cash flow). Using leverage can boost your cash-on-cash returns even more.
Rental properties can generate returns first and foremost from ongoing cash flow/income, rather than appreciation/growth. In contrast, stocks generate far more of their returns from appreciation and growth, with dividends making up a much smaller proportion of their total returns. That makes it hard to live on dividends alone—precisely why retirees typically have to sell off stocks over time to fund their retirement.
Rents also rise alongside (and often surpassing) inflation. Unlike bond returns, you don’t have to subtract out inflation to calculate rentals’ real return. In fact, rising rents create disproportionate growth in cash flow and profit margins.
Consider a simple example: You buy a property that rents for $1,000/month, and you pay a $500 mortgage. The next year, you raise the rent by 3% to $1,030, but the margin between your mortgage payment and the rent actually grows by 6% ($30/$500). It’s an oversimplified example, as you’ll also have some non-mortgage expenses that rise alongside rents, but it illustrates the point that your profit margin rises disproportionately faster than your total rent increases.
Another perk lies in real estate’s tax advantages. You can deduct or depreciate nearly every conceivable expense, often allowing you to take a paper loss to reduce your tax bill even as you earn money in real life.
A Sample $1 Million Creative Retirement
Following the 4% rule, a $1 million retirement generates only $40,000—nothing to write home about.
But let’s get more creative with retiring on $1 million. To begin, I’m throwing out bonds entirely. In the new millennium, they have remained perpetually low. At the time of this writing, 10-year Treasury notes pay an appalling 0.66%. That’s significantly lower than typical inflation, so you’d probably lose money investing in them.
That leaves me with a core investing strategy that combines stocks and real estate, both of which generate high returns over the long-term. Imagine I aim for 40% stocks, 40% direct rental property ownership, and 20% indirect real estate investments. That gives me $400,000 in stocks, which would generate $16,000 per year if I followed the 4% rule.
With my rentals, let’s say I earn 10% cash-on-cash returns, using leverage to build a diverse portfolio. I put $40,000 down on 10 properties, for a total cash investment of $400,000 and a total portfolio value of $2 million. That gives me $40,000 per year in rental cash flow, not counting any appreciation, tax advantages, margin growth over time, and the eventual expiration of my mortgages to skyrocket my cash flow.
Finally, I invest in real estate indirectly through several means. I invest in private REITs, such as Fundrise and Streitwise, for strong dividends and diversification. I also lend money against real estate, both through crowdfunded platforms like Groundfloor and through private notes to investors I personally and trust. That combines for an average return of around 9%. At $200,000 that would generate another $18,000 in annual income.
Combined, I would then earn $74,000 per year on my $1 million nest egg—not a jet-setter income by any stretch but far greater than the 4% rule’s $40,000. And if you want to retire early, just switch the 4% withdrawal rate on stocks to 3.5%, which would only drop your annual income by $2,000.
Surprise Savings While Pursuing FIRE
If you do opt to pursue financial independence at an early age, you’ll be pleasantly surprised by some of the hidden benefits and savings. With low living expenses and a high savings rate, you can pay off expensive debts quickly and avoid high interest. People with no unsecured debts, a high savings rate, and a relatively strong net worth also qualify for cheaper secured loans, paying less in interest and fees when they take out a mortgage or auto loan.
An ever-expanding net worth and passive income can also help you avoid life insurance and long-term disability insurance. If your family doesn’t rely on your day job to survive, you don’t need them! For example, my wife and I live on her income and invest all of mine. If one of us died, the survivor would have no trouble continuing to pay the bills. That means we can avoid the expenses of life insurance and disability insurance and put that savings toward our investments.
The less you need your day job to survive, the better position you’re in to negotiate a higher salary and benefits. Use that bargaining power to negotiate higher income than you’d otherwise have the guts to do.
You’re also in a better position to work remotely and save money in countless ways. First, you can move to an area with a lower cost of living. As I mentioned, my wife and I lead a very comfortable life in Brazil on her modest salary. You can also avoid the cost of commuting—when I entered the average commute of 19.7 miles into CommuterConnections.org’s free calculator, it returned a jarring $5,848 per year as the total cost. You also avoid the need to buy all those work clothes, shoes, accessories, and other status symbols. I work in my workout clothes every day and can’t remember the last time I spent a cent on professional clothes!
Finally, you can structure your wealth and income to pay a lower tax rate. Between capitalizing on tax-sheltered accounts like IRAs and HSAs, not having to pay payroll taxes on your ever-increasing passive income, leaning more on capital gains rather than W-2 income, and of course the tax advantages inherent in real estate, you can stop hemorrhaging so much of your money to Uncle Sam.
I could confidently retire on $1 million. But then again, I’ve built an entire lifestyle around low cost of living. I don’t pay for housing, don’t own a car, and live overseas in a country with low cost of living. I also invest more diversely and in higher-yield assets than the average Joe.
Can you retire on $1 million? It depends on your living expenses and your investing strategy. What’s certain, however, is that a $1 million retirement is not a luxury retirement, at least in the United States. At best, you can expect a middle-class lifestyle on a $1 million retirement in the U.S.
If you want a ritzier retirement, you need to either save and invest more, lower your living expenses through tricks like house hacking or moving somewhere with a low cost of living, or ideally both.
As a last thought, consider reframing how you measure retirement readiness. Focus less on net worth and more on your FIRE ratio: the percentage of your living expenses that you can cover with passive income. When you reach 100%, congratulations! You’re financially independent.
What are your retirement goals? How do you plan to achieve them?
Share your thoughts below!